In: Business and Management

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1. Imagine you are Bill. How would you explain to Mary the relationship between risk and return of individual stocks?

If I were Bill, I would explain to Mary that the relationship between risk and return is simply the additional compensation for bearing risk. If she were to invest in more risky securities, the return may be higher, but if the market falls, her losses could also be quite large. With risky assets, the possibility of it losing value is also greater, compared to a risk-free or low-risk asset. As Mary is described to be a ‘conservative and cautious’ person, she would need to move out of risky assets and invest in lower-risk securities. In order to have a guaranteed expected return, she must invest in securities or assets that are low-risk but would not have as big of a return

2. Mary has no idea what Beta means and how it is related to the required return of her stocks. Explain how you would help her understand these concepts.
The Beta is an indication of the amount of systematic risk present in a risky investment, compared to an average risky asset. The beta only represents systematic risk, as unsystematic risk can be diversified enough that it does not exist. An asset with a beta of 1 means that it is of average risk compared to the market. Essentially, the beta of a particular asset will tell you how the stock will perform if the market were to change. If the asset Mary is holding as a beta of 2, and the market dropped by 20%, that particular risky asset with a beta of 2 will drop by 40%. Securities with high beta will have high volatility. Assets with a beta of less than 1 indicate that these are very low-risk or risk-free…...

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